The Volokh Conspiracy

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"Consumer Credit and the American Economy," Part 4: Consumers and High-Cost Credit


This essay continues a short review of some ideas discussed at greater length in Consumer Credit and the American Economy, a new book by Thomas A. Durkin, Gregory Elliehausen, Michael E. Staten, and Todd J. Zywicki (Oxford University Press, August, 2014). The first essay examined economic reasons why consumer credit use is widespread, the second at the question whether consumer credit use is excessive, and the third at evidence of psychological influences on the economics of consumer credit use. This essay looks at why consumers may sometimes use small amounts of high cost credit.

Consumers and High Cost Credit

Some consumer credit products have gained special notoriety in recent years because of their apparently high prices, as evidenced by high annual percentage rates and their use by lower-income, credit-impaired, or other less fortunate consumers. The products in question include pawnbroker loans, some kinds of small personal installment loans, payday loans, subprime credit cards, automobile title loans, and income tax refund anticipation loans. Although they are sometimes called "fringe" products because of the relatively small amounts of money typically involved, they are used by millions of people every year.

Prices for these fringe credit products are indeed high when expressed in terms of annual percentage rates required under Truth in Lending. Finance charges are large relative to the small loan amounts, and terms to maturity are short. Under these circumstances, annual percentage rates often exceed 100 percent. Not surprisingly, triple-digit interest rates invite widespread criticism. The critics of high-rate credit products often contend that consumers would be better off without such borrowing opportunities. They see little or no benefit to using high-rate credit and assert that high-rate credit products contain great potential to harm consumers. They declare further that consumers using such products often are uninformed or sometimes misled, often supporting these views using anecdotes and stories. There clearly are instances when consumers have suffered harm and have been uninformed or misled when they used these products, but systematic evidence on frequency of problems or the extent to which use of high-rate credit may be informed has been limited. That these products visibly remain in demand, and even seem to be gaining in popularity, suggests the usefulness of further analysis.

Review usefully can begin with the economic intertemporal consumption and investment decision model originally developed by Fisher, Hirshleifer, Juster and Shay, and others and discussed previously. This economic model of consumer credit use predicts the characteristics of consumers that may benefit from high-rate credit. Then the psychologists' model of the decision process can provide criteria for assessing the extent to which these consumers' behavior is purposive and intelligent.

In their economic analyses of the consumer's credit decision, Juster and Shay explained why consumers are sometimes willing to borrow at high rates of interest. First, as discussed earlier in this series, many durable products and services purchased using credit provide benefits over a period of time and that for some families, the implied rates of return for these benefits can be quite high. But because income and accumulated savings are finite, lenders limit the amount of credit they are willing to offer any consumer. Consequently, the rate of return from additional investment in durables may exceed the marginal borrowing cost from primary lenders but still be less than the cost of sacrifice of current consumption of other things or reduction in savings necessary to acquire additional durable goods. When this situation occurs, consumers are said to be credit constrained or rationed by the primary lenders. Specialized secondary lenders willing to lend small amounts at relatively high rates can relax the credit constraint and increase utility, but the rates of charge can be high due to the necessity of recovering the operating cost of production from relatively small balances of the credit outstanding.

Such rationed borrowers are likely to be in early family life cycle stages. For them, rates of return on household investment tend to be high. They tend to have relatively low or moderate current incomes and little discretionary income, making the sacrifices in current consumption to pay for large expenses personally costly. And because of their moderate incomes and young age, rationed borrowers generally would not have accumulated large amounts of liquid assets. At this stage in the life cycle, their liquid asset holdings have a high subjective yield because of precautionary savings motives.

Unrationed borrowers, in contrast, likely are more often in later family life cycle stages or have relatively high incomes. Unrationed borrowers in later life cycle stages may have relatively few high-return household investment opportunities. Higher income and more available savings may provide discretionary amounts that allow for relatively large expenditures without costly reductions in current consumption. For them, subjective yields on liquid assets can be substantially lower for unrationed borrowers than for rationed borrowers. Availability of low-cost discretionary income and liquid assets would make unrationed borrowers generally unwilling to pay high interest rates for additional credit.

For consumers' individual reviews of their situations, the benefits from durable goods acquisitions can often be measured in dollars as saved costs (for example, home appliances and repairs) or as enhanced opportunities (for example, transportation from automobiles). Likewise, benefits of using a short-term loan may also be analyzed in terms of the costs of some market alternative. For example, a short-term loan may be used to avoid a late payment or some other costly outcome, or to take advantage of a one-time opportunity like a sale.

Reviewing available empirical evidence about the users of high-cost credit products shows that consumers using different types of high-rate loans tend to be in age, life cycle, and income groups that are associated with strong demand for credit and are often rationed. They mostly are relatively young, are in early family life cycle stages, and have lower or moderate incomes, depending on the product. Some of these consumers (payday loan and tax refund anticipation loan customers with bank accounts) are more likely to use closed-end credit than all families and are apt to have higher debt burdens than families with debt generally. Others (pawnbroker, tax refund anticipation loan customers without bank accounts, and rent-to-own customers) are less likely than all families to use mainstream credit products. Regardless of their use of mainstream credit products, many high-rate credit customers have characteristics that limit their access to credit, and most have experienced turndowns or perceive that they are constrained. Thus, the consumers who use high-rate loans are generally ones who economic theory predicts might benefit from relaxation of credit constraints. In itself this does not indicate that their use of such credit is rational, but it does suggest that their circumstances are such that use of high-APR credit may be utility-increasing.

To understand consumers' choices involving high-rate credit products, researchers have turned to cognitive models of consumers' decision processes from psychology, including buyer behavior models and related constructs. Viewed this way (and discussed last time), the consumer's decision is a process that occurs over several stages: problem recognition, internal and external search for information, choice, and outcome evaluation. These stages are interrelated, with feedback occurring throughout the process. Developments during each stage may cause the process to stop, move to the next stage, or proceed immediately to the purchase. Consumers may simplify, use heuristics, or take shortcuts during the decision process. They and economists also recognize that consumers may not obtain complete information about alternatives before making decisions. In the economist's framework, acquisition of information may be costly. A consumer will acquire additional information only if its expected benefit exceeds the cost.

In general, these hallmarks of extended decision-making processes do not describe the circumstances typically involved in choosing high-rate credit products; high-rate credit products have characteristics associated with limited decision processes. Concerning product characteristics, most are relatively short term. Also, because loan amount is usually small, the finance charge is high relative to loan amount but not generally relative to the borrower's monthly income. Deliberation for such purchases may be strongly focused on one aspect of the purchase to the exclusion of others and still be purposive and entirely rational. These psychology-based behavioral models suggest that extensive collection of information and weighing of all available alternatives may not always be necessary for purposive and intelligent decisions. In fact, focusing on the psychological aspects of the decision to use credit for purchasing durable goods on credit, pioneer analyst George Katona noted in 1975 in his classic Psychological Economics that if careful deliberation were defined as including all features of decision making-consideration of alternatives and consequences, discussion with family members, information seeking, and concern with price, brand, quality, performance, special features, and gadgets-the conclusion would emerge that almost all people proceed in a careless way in purchasing large household goods. This conclusion, however, seems unwarranted, especially for shorter-term purchases of a more urgent nature.

Further, situational factors may also limit decision processes. A short term to maturity makes high-price credit products more suited to addressing temporary shortfalls in funds than financing investment in durable goods that might last years. Temporary shortfalls may often be the result of unexpected expenses and may therefore be viewed as urgent. Moreover, short-term use to address temporary shortfalls in cash may involve relatively short time periods since previous decisions. In such situations, consumers may perceive that information obtained from previous decisions is not obsolete.

With this as background, empirical research evidence shows that many users of high cost "fringe" credit products show signs of deliberation in their decisions, but most probably do not undertake an extended decision process. Many customers have previous experience with the product and may not exert much effort in subsequent decisions. Relatively low loan amounts and short terms to maturity also may contribute to lack of awareness and lack of deliberation. Customers are largely satisfied with their decisions and generally do not believe that they have insufficient information. In this way, decision processes for high-price credit products do not appear to be much different from decision processes for mainstream credit products. The decision to use high-price credit typically is a result of the consumer's situation rather than a lack of knowledge or information.

Evidence also shows that most consumers using high-rate credit products are aware of the cost of such credit. They generally are able to recall reasonably accurate finance charges but are largely unaware of annual percentage rates for recent loans. Because most high-rate loan products have a short term to maturity, knowledge of the finance charge is generally sufficient for making informed decisions. Under this circumstance, consumers can evaluate costs and benefits without consideration of their timing. Net undiscounted benefits will not differ much from net present value of benefits.

To date, efforts to determine whether the economy as a whole actually benefits from high-rate credit products have focused largely on payday loans. They have examined a wide variety of outcomes, many of which are quite far removed from the circumstances of the payday loan decision. That a $300 two-week loan used by a very small proportion of the population could significantly influence outcomes such as property crime rates, bankruptcy rates, job performance, or check returns seems almost incredible. To be convincing, these studies must ensure that the differences in outcomes are caused by differences in payday loan access rather than something else and that the consumers who have access to payday loans are similar to consumers who do not.

It is not clear that these studies have succeeded. State laws that regulate payday lending are the product of a political process that also produces laws affecting many other aspects of the local economic and social environment, including the availability of other financial services, quality of educational services, and types of employment opportunities. A state that sharply limits personal or auto loan rates, for example, would hardly be inclined to authorize rate ceilings that permit payday lending. Geographic proximity or accounting for differences in a limited set of economic or social variables is unlikely to eliminate entirely the effects of other influences on outcomes. Thus, while suggestive, these studies are not fully convincing

There clearly also is considerable room for more micro-oriented research into specific effects of availability of high-rate credit, although such studies can be very expensive and difficult if they involve survey work. Nonetheless, it is likely there will be more of this work in the future.

Tomorrow: Regulation of Consumer Credit